Business risk of GSAP they are going to buy: that it will not fail o Business risk= more business risk means more variability in operating profit which means a higher beta so adjust the Beta coefficient to match it with the level of financial risk incurred by the company.
• Beta: Sterling’s proposed acquisition is 0.99 (beta is leveraged on the debt/equity ratio) [Exhibit 7]
• Growth opportunities were limited and its business was under constant pressure
• The company’s annual sales volume (in units) had increased by less than 1% per year, because of weak growth in overall demand and other company competition, which gives consumers the ability to choose other products
• Business risk of buying at $265 million: relevantly low (where there
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• If PE ratios show how much growth (Montagne is growing better and faster) o Sterling expenses are going more than depreciation which is lower than Montagne o Expected to have Montagne PE to be higher (not only by a 0.2 difference)
• PE of Montagne is so low and PE of Sterling is so high because it is over valued o Very diversified with beta
• [Exhibit 1] Sterling’s operating expenses and commodities costs = rising faster than inflation rate: therefore more pressure on business profits
Financial risk: by looking at the trends of coverage ratios, there is medium financial risk because Sterling is doing the borrowing o The higher working capital rate of Montagne Medical indicated financial risk in the Medicare/Healthcare market o Receivables are outstanding longer and there are greater risks of write offs for future o Inventory rates are higher and should be financially controlled/overlooked
Beta [Exhibit 3]:
• Beta for division: they are buying which is not the same for overall (diversified business)
• Do not have returns for the division they are buying in
• Division doesn’t trade in the market (doesn’t have a market price)- main challenge
• Value of beta = 0.99
• Market premium = 5.0%
• Risk free rate =
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Recommendations:
• I would suggest (from an analytical perspective) getting the terminal value to estimate the expected value of unit acquisition with 2.2% growth rate o Also suggest not to acquire Montagne (business and financial risk on Sterling Company)
• Sterling’s management should focus on the acquisition of Germicidal, Sanitation, and Antiseptic product division of Montagne Medical= high potentials of synergies (market for germicidal, sanitation and antiseptic products for use is growing fast
• Device a monthly liquidity plan, keep contacts from Montagne Medical, and increase cash/short term bank payables after purchase o Risk in short term liquidity increases because higher working capital
Explain why you would either make this acquisition or pass it up:
• Valuation: free cash flow: EBIT + (1- tax rate)
• Value of the unit acquisition = $ 171 million
• It will not be worthwhile or successful (financially) for Sterling to acquire Montagne because its calculated value is less than purchase price
• Discounted cash flows for the unit acquisition (without the option of capacity expansion): o Unit of the Montagne is not worth $265 million o Calculated worth of the unit is to be less than the negotiated value of $265